An often invoked (and controversially debated) proposition in environmental economics is that it would be better to alleviate the pressure from “distortionary” taxes (especially income taxes) and switch the burden to environmental taxation – e.g., a carbon tax. This sounds very reasonable – why should we tax what we want more of (labour, income), when we can tax what we want less of (e.g., pollution). This is also known under the name of a “double dividend” (dividend 1: the environmental impact; dividend 2: removal of distortions, especially in the labour market). But, reasonable and tempting as it sounds, this approach has its downsides. The main two are: the aspect of “distortionarity”, and the tradeoff between efficiency and revenue.
Let us begin with the former. It is claimed that taxes generally are distortionary. They indeed are (since they create incentives, which sometimes are contradictory; they change equilibrium prices etc.), and it has been estimated that income and related taxes are very costly, due to these distortions. So, the argument goes, let us impose a tax that is a priori non-distortionary, i.e., a Pigou tax. The aim of this tax, theoretically designed by Arthur Cecil Pigou in 1920, is to fully internalize an environmental externality, so that the economy reach the social optimum. The problem with this approach: Pigovian taxes are a theoretical construct. We are not able to 1) find out how large the costs of the externality in consideration are, 2) find out who is responsible for it to which extent, 3) impose a tax that would exactly correct for the negative effect. This is not to say that environmental taxes are doomed to failure – but they surely are not non-distortionary. That they nevertheless can make sense and how to design them was shown by Baumol and Oates in “The Theory of Environmental Policy” (1975), where they proposed the so called Price-Standard approach (setting a “political” standard and then finding a price and an instrument to efficiently reach it). So, environmental taxes (e.g., a carbon tax) are distortionary. Nevertheless, this is not necessarily an argument against them – but it shows that they cannot really reach the “double dividend” in its strict sense: distortions remain. On the other hand, the argument that it is better to tax “bads” (environmental damage) than “goods” (labour) still holds. We move now to the second downside: the tradeoff between efficiency and revenue.
Taxes have generally two important functions: they provide incentives for socially desired behaviour (e.g., less pollution), and they raise the revenue the State needs to provide its services, especially the provision of public goods (i.e., infrastructure, education, health care…). The problem here is that there is a tradeoff between both functions: when the (carbon) tax is properly designed, then it provides incentives for the actors to lower their emissions (by investing in new technologies and/or in efficiency measures). Since emissions go down, the revenue from the tax does as well. Thus its “second dividend” (in the wider sense of alleviating the tax pressure on labour) diminishes. On the other hand, if the tax is designed as to bring in a large revenue, then the incentives for emissions reduction have to be weak – ecological efficiency is given up.
In my opinion, the first aspect discussed here is not that relevant: even while recognizing the fact that environmental taxes are indeed distortionary, one may and should emphasize that it is nonetheless better to tax, e.g., pollution than labour. But my second point – the tradeoff between efficiency and revenue, still holds. What we can learn from that? Maybe it is enough to say that proper incentives are important – without seeking further justifications for environmental taxation. Furthermore, since we hardly want to incentivize full surrender of, e.g., carbon emissions (at least not in the short to middle run), there certainly would be some additional revenue. We may not be able to significantly lower income and related taxes, but some alleviation would still be possible.
One must not claim to have found a “perfect solution” to show that her proposal is useful.